The Closing Bell-7/10/10
Steve Cook on Disciplined Investing

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Next week will start a month of travel.  I will be on vacation next week.  I’ll be back the following week.  Then we go to a nephew’s wedding and since it is at the beach, we will take some extra days.  Then back for a week.  Then grandchildren come for a visit. Then back for a week.  During this period, I will be in close touch with the Market; so while I won’t doing the Morning Calls, if action is required, I will be in touch via Subscriber Alerts.  However,  I then go to a three day retreat and will be in total lock down.

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Statistical Summary

   Current Economic Forecast
   
2009
    Real Growth in Gross Domestic Product:        -1.0 - -2.0%
    Inflation:                                                                       1-2 %
    Growth in Corporate Profits:                                    0- -5%

    2010 (revised)

   Real Growth in Gross Domestic Product:          +3.0- +4.0%
   Inflation:                                                                     1.5-2.5 %
   Growth in Corporate Profits:                                       10-20%

 Current Market Forecast
   
    Dow Jones Industrial Average

       Current Trend (revised):
         Short Term Down Trend                                      9182-10343
         Long Term Trading Range                                  6432-14180
                    
        2009    Year End Fair Value                                9440-9460

        2010    Year End Fair Value (revised)                 10120-10140
 
    Standard & Poor’s 500

        Current Trend (revised):
           Short Term Down Trend                                         980-1104
           Long Term Trading Range                                    666-1575
               
            2009    Year End Fair Value                                1165-1185

           2010    Year End Fair Value                                    1250-1270   

  Percentage Cash in Our Portfolios

    Dividend Growth Portfolio                  22%
    High Yield Portfolio                             21%
    Aggressive Growth Portfolio             23%

Economics
   
The condition of the recovery remains  uncertain, making the economy,  for the moment, a neutral  for Your Money.
  There were few stats this week but what there was I considered generally better than we have gotten over the last month.  Of course, this could be chalked up to nothing more than randomness; so it would be premature to speculate on whether or not the more favorable results mean that June will have proven to be a transition month in which  the economy stabilized and began showing more positive signs of growth.  Whatever the reason, the data we got was better than a sharp stick in the eye.

Given the dearth of US economic measures, investor attention shifted back to the political and international ‘headwinds’; and by and large, this week’s developments both clarified the outlook and offered big potential pluses.  I say ‘potential’ because they all came with caveats and some well deserved skepticism.  That is not to say that they didn’t provide some clarity, that they didn’t report progress being made or that there were no positives; it is just that they don’t necessarily tell us how these ‘headwinds’ will be resolved.

(1)    BP announced that its relief well was 15 feet from the leaking well.  That is great except the really hard part, i.e. the capping and redirection of the oil flow from the leaking well Angel may still take till mid August and Beer may not be successful.  No one is suggesting that correcting this situation is a lock,

(2)    the International Monetary Fund revised up its 2010 outlook for global growth.  Another positive especially given concerns that a worldwide economic slowdown could help push the US economy into a double dip.  I caution though that the IMF is notorious for missing the mark in its forecasts,

(3)    the EU continued to make more revelations regarding the terms of its bank ‘stress test’.  On the surface, those terms appear to be more encompassing and more stringent than most investors had originally assumed.  However, guys smarter and more knowledgeable than I are highly critical and suggest that the ‘tests’ are nothing but show and do little to cure the near insolvency of the banking system.

(4)    Obama and Geithner are on a PR offensive, holding out an olive branch to the business community, specifically Angel capping the tax on dividends and capital gains at 20% {now 15%} when the Bush tax cuts expire and Beer pursuing more free trade policies {cease ragging China over its currency policy and attempt to push through several free trade agreements}.  I would note Angel a change in tax policy requires the congress, Beer passage of a free trade agreement requires the senate and Coffee the elections are three months away and Obama, if nothing else, is a cynical political operative.

And there is this just to keep Him in perspective (long):
http://www.weeklystandard.com/articles/one-job-forward-two-jobs-back

Bottom line: all that said, each of the above still holds the potential to be a major economic positive.  Of course, as I noted, there is enough ‘hair’ on each to make it is unlikely that they will all prove to be pluses.  On the other hand, it would probably be equally unrealistic to assume that none of these factors will ultimately lead to an improved outlook for the US economy.  So as skeptical as I may be on any one of them, I believe that in total the prospects for a double dip have lessened and the odds of our short term forecast (an economy struggling but nonetheless growing) playing out have gotten better.  Indeed, there is even some chance that the longer term outlook (an economy growing but at an historically below average pace) could be somewhat improved if Obama is not faking His recent Clintonesque moves to the center--but I am not making any bets on that one.

On the other hand, the ECRI just keeps dropping (suggesting an increasing probability of a recession--short):
http://www.zerohedge.com/article/another-week-another-drop-ecri-index-another-bizarro-reason-chase-stocks-higher

This week’s data:

(1)    housing: weekly mortgage applications fell 2.0%,
 
(2)    consumer: weekly retail sales showed broad improvement for the first time in a month; June retail same store sales were up but slightly less than expected; weekly jobless claims fell more than expected; the really bad piece of news this week was a big drop in May consumer credit; however, this was a May number which we already know was a lousy month,

(3)    industry: the June ISM nonmanufacturing index came in below expectations; May wholesale inventories climbed 0.5%. a bit more than forecast; however, May wholesale sales fell 0.3%, driving up the inventory to sales ratio--that’s a negative,

(4)    macro:  no data this week.

    The Economic Risks:

(1)    the economy is weaker than expected.

(2) Fed policy (reading the data correctly). 

(3) a disruption in global oil supplies (It is not the price of oil but its availability that will cause severe economic dislocation.).

(4) protectionism (Free trade is a major positive for world and US economic growth.).

(5) fiscal profligacy (Government spending as a percent of GDP is too high and the looming explosion in entitlement expenditures will make it worse.  There is no good solution save spending discipline.).
       
(6) a rising tax and regulatory burden (Government has never proven that it could solve economic problems efficiently or satisfactorily.)

Politics

Both the domestic and international political environments are negative for Your Money.
       
    Inflation or deflation (long but a good read):
    http://www.ritholtz.com/blog/2010/07/deflation-or-inflation-which-is-it/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29&utm_content=Yahoo!+Mail

The Market-Disciplined Investing
    
  Technical

Despite a blockbuster week, the Averages (DJIA 10198, S&P 1077) remain within a down trend marked by 9182-10343, 980-1104.  Further, the rally was on very low volume (it was virtually nonexistent Friday) and mediocre breadth (it weakened again on Friday). 

On the other hand, two positives continue to signal that 9645, 1009 marked the bottom:  (1) the VIX which fell once again on Friday but remains above its most recent support level.  This index already suggests that the worst is over; breaking the aforementioned support level would argue that stocks will re-establish their up trend, (2) our internal indicator continues to improve.  Like the VIX, it is telling us that the 9645, 1009 level was the bottom.

Clearly, having Sold stocks when the Market broke the 9830, 1042 level, I am on the wrong side of trade at the moment.  That kind of thing happens with any technical discipline--the operative word being discipline. The key is to be follow the discipline with consistency.  It won’t always be right; but it has the rules that tells us the point at which to admit our mistake so that we are not on the wrong side of the trade long enough to lose a lot of money or suffer a large opportunity cost.  As of the close Friday under our Discipline, the indices are in an easily identifiable down trend. We will know that they are not when prices break the upper boundary of the down trend (10343, 1104). 

On the other hand, if stock prices reverse themselves but the VIX and our internal indicator continue to give off positive vibes, then I believe that there is a reasonable probability that the 9645, 1009 level could hold.  However to be clear, our Discipline demands that we await rather than anticipate such an occurrence.

Bottom line:

(1) short term, the indices are in a down trend defined by 9182-10343, 980-1104,

(2)    long term, stocks are in a trading range defined by the 2002/2009 lows [S&P 666-766] and the 2000/2007 highs [1545-1575].  Importantly, I think that equity prices will continue to recover within that range but it will be a slow and volatile process.

The argument for a continuing advance in stock prices--at least in the short term (short):
http://www.ritholtz.com/blog/2010/07/update-on-bullbear-sentiment/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29&utm_content=Yahoo!+Mail

    And one for an extended period of sluggish performance (short)
    http://www.ritholtz.com/blog/2010/07/comparing-djia-recession-recoveries/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29&utm_content=Yahoo!+Mail

   Fundamental-A Dividend Growth Investment Strategy

    The DJIA (10343) finished this week about 5.0% above Fair Value (9850) while the S&P closed (1077) around 12.0% undervalued (1225).
 
The good news is that there were positive developments among the  bad news factors that I listed in last week’s Closing Bell--most of which I have already addressed above: (1) the economic data improved this week, including the revised up beat forecast from the IMF,  (2) the administration is starting to make pro-business comments, (3) the EU is stumbling toward resolution of its financial institutions balance sheet problems, (4) the drill hole of BP’s relief well is near the leaking well and we will soon know if their plan for capping/redirecting the flow of that well works.  As I said above, it is not likely that  all will lead to positive results; but it is also not likely that none will.  Hence, though it may not be measurable, some progress was made this week toward clarity and resolution of these problems.
 http://mjperry.blogspot.com/2010/07/oecd-leading-index-increases-for-15th.html

The even better news is that the good news points that were in last week’s list haven’t changed:  ‘(1) corporate balance are flush with cash, (2) second quarter earnings are apt to be good [though the big question  may be the how good the guidance is] , (3) the ‘bad’ news out of China simply isn’t that bad, (4) at 12% below Fair Value [at least by our Model’s valuation of the S&P] stock prices are reflecting at least a portion of the bad news and (5)  as lousy as the current political approach to solving our economic problems is, if the polls are anywhere near correct, regime change is going to occur in four months; and sooner or later, stocks are going to start to discount that.’

Nevertheless, the fact remains that stocks are in a down trend; and I am not going to risk additional assets in our Portfolios until there is reason to believe the worst is over, i.e. prices successfully challenge the upper boundary of the current down trend or they either unsuccessfully challenge the prior low (9645, 1009) or make a higher low.
 
This week, the Dividend Growth and Aggressive Growth Portfolios took additional steps to lightened up on stocks that experienced a technical breakdown.

           Bottom line:

(1)      our Portfolios will carry a higher cash balance than pre-financial crisis but it will be more a function of individual stock valuations and less on macro Market technical trends,
 
(2)    we continue to include gold and foreign ETF’s in our asset mix because we continue to believe that inflation is the major long term risk.  An investment in gold is an inflation hedge and holdings in other countries provide Angel a hedge against a weak dollar and Beer exposure to better growth opportunities,

(3)    defense is still important.

                                                                      DJIA                    S&P

Current 2010 Year End Fair Value*        10130                    1260
Fair Value as of 7/31/10                            9850                    1225
Close this week                                          10343                   1104

Over Valuation vs. 7/31 Close
      5% overvalued                                       10342                    1286
    10% overvalued                                       10835                     1347 
    15% overvalued                                       11327                    1408

Under Valuation vs. 7/31 Close
    5% undervalued                                       9357                      1163
   10%undervalued                                       8865                      1102
    15%undervalued                                        8372                    1041   

* Just a reminder that the Year End Fair Value number is based on the long term secular growth of the earning power of productive capacity of the US economy not the near term   cyclical influences.  The model is now accounting for somewhat below average secular growth for the next 3 to 5 years with somewhat higher inflation. 

The Portfolios and Buy Lists are up to date.


Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973.  His 40 years of investment experience includes institutional portfolio management at Scudder. Stevens and Clark and Bear Stearns,  managing a risk arbitrage hedge fund and an investment banking boutique specializing in funding second stage private companies.  Through his involvement with Strategic Stock Investments, Steve hopes that his experience can help other investors build their wealth while avoiding tough lessons that he learned the hard way.









Posted 07-10-2010 11:21 AM by Steve Cook